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ACCTG 371 MODULE 1: FRAMEWORK FOR FINANCIAL

STATEMENT ANALYSIS & VALUATION


Valuing assets & equity securities (ordinary shares)
LO: Users & suppliers of F/S info; 4 F/S & acctg equation; business analysis in
context of competitive environment; profitability analysis; acctg principles &
regulations framing F/S
Berkshire Hathaways Acquisition Criteria (investment company)
1. large purchases (& pretax earnings)
2. consistent earning power (future projection irrelevant, neither are
turnarounds); good cash flows (affects SPrice = net worth of firm for
investors)
3. business earning good returns on equity while employing little/no debt
4. management in place (we cannot supply)
5. simple businesses (not many technologies)
6. an offering price
Financial Statement Analysis & Valuation
1. F/S Analysis: process of extracting info from F/S to better understand
companys current & future performance & financial condition
2. Valuation: process of drawing on results of analysis to estimate companys
value/worth (of debt or equity securities = value of firms total assets)

Step 2:
fin. performance & resultant financial position/condition.
Step 3: future predicted performance
Step 4: present value total assets (debt + equity securities) or net worth (value
of equity securities/shares) = decision of investing

Step 1: Business Environment & Accounting Information


Firms business activities: financing, investing, operating
Business forces impact how well firm performs activities: market constraints &
competitive pressures impacting firm. To reduce their adverse effects, firms
prepare business plans to achieve goals & identify when corrective actions
needed.
Source of info for bus. plans arise from prior & current F/S.
Understanding BP helps analyst focus F/S analysis by placing analysis in proper
context: appropriately assess fin. perf. & position given env. firm operates in. In
order to understand bus. env. & acctg info business operates in, demand for fin.
acctg. info. is created,

Financial Accounting Information: Demand & Supply


-

managers & employees


investment analysts & info intermediaries
shareholders, directors
customers, strategic partners
regulators, tax agencies
voters & their representatives

Demand due to variety of reasons (amount of dividends firm pays, make


policies/regulations, lending decisions). Firms present general purpose F/S to
satisfy demand from users.
Supply of Acctg Info (quantity & quality provided):
-

determined by managers & regulators (setting minimum disclosures)


primary SEC (security & exchange) annual report filing requirements (form
10-K annual, 10-Q quarterly). NZ: annual reports to companies office
benefits of disclosure: lower costs of funds (good prospects reflected by
acctg info; investors more willing to invest at decreased cost of capital;
lower interest charged by creditors due to perceived lower risk) & labour,

economic benefits form reliable disclosures (unqualified opinion from


auditors; users place higher value on firm as info verified; reduces info
uncertainty)
costs of disclosure: preparation & dissemination (production costs),
competitive disadvantages (due to disclosure, info is proprietary),
litigation potential (info used against firm; financial expectations not
upheld, potential civil lawsuits), adverse political costs (affects value)

International Acctg Standards & Convergence


International Acctg Standards Board (IASB) oversees development of acctg
standards for countries outside US & regulates supply fin. info.
FASB (USA) & IASB: development high-quality, compatible acctg standards used
for both domestic & cross-border financial reporting (GAAP to converge with
IFRS)
a) make existing financial reporting standards fully compatible
b) coordinate future work programs to ensure compatibility maintained.
GAAP vs IFRS
Both accrual acctg & similar conceptual frameworks.
Both same set F/S (SOFP, SOCI, SOCF, statement of stockholders equity &
explanatory footnotes)
Differences technical in nature, do not differ on broad principles.

Accounting Equation

Balance Sheet

Investing & Financing Activities


Debt: implications on riskiness
Balance Sheet
-

Investment-type companies (Berkshire Hathaway) & high-tech (Cisco


Systems) carry high levels cash (costs of holding cash)
Relative proportion short & long-term assets dictated by business models
(composition of assets on SOFP in same industry similar; can deviate from
industry norm by small degree)

Trade-offs in financing company by owner vs. non-owner financing (nonowner financing less costly)
Shareholders & long-term creditors influence strategic direction of
company
A & L reported on SOFP at acquisition price (historical cost instead of fair
value)

Income Statement
Operating activities: lists amounts of sales (revenues) less expenses (costs) over
period of time.
Sales expenses = net income

Trends; net income as percentage of sales; factors driving success (competitive


threat)
-

Sale recognised when made, not when cash collected.

When company purchases long-term asset (buildings), cost reported on


SOFP as asset (not expense on SOCI). Report cost of asset over course of
useful life as depreciation.
Manufacturers & merchandisers report cost of product as expense when
sale recorded.
Using cash as base of measurement problematic for financial reporting.
If asset increase in value, increase not reported as income until building
sold (if record increases in asset values as part of income when
measurement based on appraised value, issues arise)
employees earn wages yet to be paid at end of particular period (ie. wages
are accrued). Recognised as expense in period work performed, not when
paid
companies are not allowed to report profit on transactions relating to own
stock (dont report income when stock sold, or expense when dividends
paid to shareholders)

Statement of Equity
Changes in accounts that make equity: contributed & earned capital (RE +
accumulated OCI); other (accumulated OCI & minority/non-controlling interest)
Owner may prefer money reinvested, not received as dividends: reinvestment
can drive further profit & growth.

Statement of Cash Flows


Operating, investing, financing activities over period of time.

provides cash flow info not reflected in SOCI & SOFP


report net cash inflows relating to operating activities over the longer term
(implications if negative for extended period of time)
composition of investment activities (positive may not be favourable)
sources of financing
composition operating, investing, financing CF changes over firms life
cycle
bottom line increase in CF may not be key number (composition changes)

Financial Statement Linkages


-

SOCI & SOFP linked via RE


Berkshire: 13213mil increase in RE (SOFP) = net income (SOCI) + 28mil
adjustment relating to adoption new acctg standard. No dividends paid.

RE, contributed capital & other equity balances appear on both statement
of stockholders equity & SOFP
SOCF linked to SOCI as net income is component of operating cash flow.
SOCF also linked to SOFP as change in SOFP cash account reflects net cash
inflows & outflows for period.

Information Beyond F/S


-

management discussion & analysis


independent auditors report
F/S footnotes
regulatory filings & proxy statements

Value Chain Model


Primary
Inbound logistics
Operations
Outbound logistics
Servicing

Competitive Analysis
-

industry competition
bargaining power buyers
bargaining power suppliers
threat substitution
threat entry

5 Forces of Competitive Intensity

Support
Firm infrastructure
HR management
Technology/product development
Procurement

Step 2: Adjusting & Assessing Financial Info


GAAP allows acceptable alternatives in preparing F/S (inventories, property,
equipment)
F/S depend on estimates
Acctg choices make info difficult to compare companies
Sarbanes-Oxley Act
SEC requires CEO & CFO of company to sign statement attesting to accuracy &
completeness of companys F/S
Commitments:
-

both CEO & CFO personally reviewed annual report

no untrue statements of material fact that would made statements


misleading
F/S fairly present in all material respects the financial condition of
company
all material facts disclosed to auditors & board of directors
no changes to its system of internal controls are made unless properly
communicated

Profitability Analysis

Profit Margin, Asset Turnover & ROA


High A turnover = high profit margin
Step 3: Forecasting Financial Numbers
Theoretical linkage between earnings & stock prices:
-

current earnings predict future


future earnings may determine expected future dividends
future dividends, when discounted, determine current stock price

Future Earnings & Excess Returns


-

excess annual returns 10-25% for earnings increases


10-25% negative returns for earnings decreases

Step 4: Company Valuation


Worth of company = current value of expected payoffs (Modules 12-14: compute
value using dividends, CF, earnings as payoffs)
Module 15: market-based valuation
Appendix 1A: Accessing SEC filings

Appendix 1B: Oversight of Financial Accounting


SEC oversees all publicly-traded companies
FASB (Finacnial acctg standards board)
PCAOB (public company acctg oversight board)

Audit Report
F/S = managements responsibility. Auditor responsibility: express opinion on
statements
Involves sampling transactions, not investigating each trans.
Audit opinion provides reasonable assurance statements free of material
misstatements, NOT guarantee
Auditors review acctg policies used by management & estimates used in
preparing statements
F/S present fairly, in all material respects, a companys financial condition, in
conformity w/GAAP (unqualified opinion)

MODULE 2: BUSINESS ACTIVITIES & FINANCIAL


STATEMENTS
1.
2.
3.
4.

balance sheet
income statement
statement of SHolders equity
statement of cash flows

BALANCE SHEET
A=L+E
Uses of funds = sources of funds
-

assets listed in order liquidity


liabilities listed in order maturity
equity = contributed capital & retained earnings

Assets
Converted into cash or used up to generate revenues
To be reported on SOFP, asset:
1. owned (controlled) by company
2. possess expected future economic benefits
Current assets: converted into cash within a year
-

cash: currency, bank deposits, investments w/original maturity <90 days


(cash equivalents)
marketable securities: short term investments quickly sold to raise cash
(net) accounts receivable: amounts due to company, from customers;
arise from sale products/services on credit (net of uncollectible accounts,
module 6)
inventory: goods purchased/produced for sale
prepaid expenses: costs paid in advance (rent, insurance, advertising)

Long-term assets:
-

PPE, net: land, factory buildings, machinery, motor vehicles, office


equipment & items used in operating activities (net of accumulated
depreciationportion of assets cost transferred from balance sheet to
SOCI, module 6)
long-term investments: does not intend to sell in near future
intangible & other assets: assets without physical substance (patents,
trademarks, franchise rights, goodwill, other costs incurred to provide
future benefits)

Cisco Systems

Assets = reported at historical cost


-

objective & verifiable


relevance (market value) vs reliability
only include items reliably measured
considerable amount assets may not be reflected on SOFP: strong
management, well-designed supply chain, superior technology

Knowledge-based assets NOT on SOFP:


-

while resources expended for research & development reflect economic


assets, generally expensed as incurred
Pharmaceutical firms do not have assets reflecting full amount money
spent developing drugs. These amounts mostly expensed in past & serve
to reduce retained earnings. Internally developed trademarks also
economic assets, but not on SOFP (but PURCHASE of externally developed
trademarks treated as assets)

Disney: market value of Mickey Mouse trademark not explicitly shown

Apples liabilities & equity:

Liabilities
Current Liabilities
Used to operate/finance business
-

accounts payable: amounts owed to suppliers for goods/services


purchased on credit
accrued liabilities: obligations for expenses incurred but unpaid (accrued
wages payable earned by employees, accrued interest payable, accrued
income taxes)
unearned revenues: obligations created when firm accepts pmt in advance
for G/S delivered in future (advances from customers, customer deposits,
deferred revenues)
short-term notes payable: short-term debt payable to banks/creditors

current maturities of long-term debt: principal portion of LTDebt due to be


paid within 1 yr

Cisco:

Net Working Capital = CA CL


Measures short-term liquidity (paying bills in short run)

Non-current liabilities
-

Cisco

long-term debt: amounts borrowed from creditors, scheduled for repmt 1


yr+ in future (any portion LTDebt due within 1 yr reclassified as current
liabilities = current maturities of LTDebt; includes bonds, mortgages,
loans)
other LT liabilities: obligations (pension & LT tax liabilities, settled 1 yr +
into future)

Equity
-

contributed capital: cash raised from issuance shares


earned capital/retained earnings
RE updated per period:
beginning RE + net income (- net loss) dividends = ending RE

Choices for owner once profits made: reinvestment (drives growth) or dividend
distribution
Equity accounts:
-

common stock: par value received from original sale of common stock to
investors
preferred stock: value received from original sale of preferred stock (fewer
ownership rights than common)
additional paid-in capital: amounts received from original sale stock to
investors in addition to par value of common stock
treasury stock: amount firm paid to reacquire common stock from
SHolders
retained earnings: accumulated net income (profit) not distributed to
SHolders as dividends
accumulated other comprehensive income/loss: accumulated changes in
equity not reported in SOCI (module 9)

Cisco Shareholders Equity:

INCOME STATEMENT

Most important line item for analysts to determine valuation for corporation =
net income

Profit margin = net income / net sales


Cisco:

Revenue recognition principle: recognise revenues when EARNED

Matching principle: recognise expenses when INCURRED


Long-run profitability: measure revenue against expenses; better predictive value
for valuation
Profit vs Cash
-

net income does not correspond to net cash flow. Firm could have good
income but poor cash flow (& vice versa). Hence 2 dimensions to consider
Balance sheet = expanded acctg equation

Operating vs Non-operating
-

operating expenses = usual, customary costs incurred to support main


business activities
non-operating expenses = financing & investing activities

Transitory Items in SOCI


-

discontinued operations: gains/losses (& net income/loss) from


business segments sold/have been sold in current period
extraordinary items: gains/losses from unusual & infrequent events

Accrual Accounting
Recognition revenue when earned (even if not received in cash) & matching of
expenses when incurred (even if unpaid in cash)
STATEMENT OF STOCKHOLDERS EQUITY

Reconciliation of beg. & ending balances of stockholders equity accounts


-

contributed capital
RE (including OCI)
treasury stock

STATEMENT OF CASH FLOWS


Reports cash inflows & outflows. Reported based on 3 business activities:
1. cash flows from operating activities: firms transactions & events relating
to its operations
2. investing: acquisitions & divestitures of investments & long-term assets
3. financing: issuances of & payment toward borrowings & equity

Cisco:

RELATION OF SOCF TO SOCI & SOFP

General Coding of Balance Sheet Changes

Working Capital Accounts

Articulation of F/S
-

F/S linked within & across time = they articulate


balance sheet & income statement linked via RE

Recording Transactions
Pay $100 wages in cash
-

cash assets -100, wage expense 100 reflected in SOCI, reducing income &
RE
all transactions incurred by company during acctg period recorded
similarly

Adjusting Accounts

Prepaid rent:

Unearned revenue:

Wage accrual:

Revenue accrual:

Exercise: The Ice Cream Store, Inc. incurred the following start-up costs (1-5).
Prepare transaction analysis 1-5 using F/S effects template

Balance Sheet:

Additional transactions:
6. On October 4, purchased merchandise inventory (i.e., ice cream) at a cost
of $15,000 by paying $5,000 cash and receiving short-term credit for the
remainder from the supplier.

7. Immediately returned some of the ice cream because some of the flavors
delivered were not ordered. The cost of the inventory returned was
$3,000.
8. Sales of ice cream for the month of October, 20XX, totaled $8,000. All
sales were for cash. The ice cream cost $3,500.
9. For all of October, total employee wages and salaries earned/paid were
$3,000.
10.As of the end of October, one month's depreciation on the equipment and
building was recognized -- $383 for the building and $167 for the
equipment.
11.$450 interest expense on the note and mortgage was due and paid on
October 31. Assume that the principal amounts ($35,000 + $60,000) of
the note and mortgage remain unchanged.
Prepare transaction analysis 6-11, using balance sheet/income statement
template

Prepare updated balance sheet as of Oct 31, 20XX & income statement for
month of October 20XX. Ignore income taxes

Preparing F/S

Balance Sheet & Income Statement

Additional Sources of Info: form 8-K


-

entry into/termination of material definitive agreement (includes petition


for bankruptsy)
exit from line of business/impairment of assets
change in companys certified public acctg firm
change in company control
departure of companys executive officers
changes in companys articles of incorporation or bylaws

Global Accounting

balance sheet: largest difference = typical IFRS-based SOFP presented in


reverse order liquidity
income statement: GAAP requires 3 years data on SOCI, IFRS req. 2
SOCF: GAAP-based SOCF classifies interest expense/revenue & dividend
revenue as operating, and dividends paid as financing. IFRS allows firm
choice between 2 options:
i) classify interest expense/revenue, dividends paid, dividend revenue as
operating, OR
ii) classify interest expense & dividends paid as financing; interest &
dividend revenue as
investing

Analyst Reports

Credit & Data Services


Credit analysis:
-

Standard & Poors


Moodys Investor Service
Fitch Ratings

Data services:
-

Thomson Corporation
First call = summary of analysts earnings forecasts
Compustat database = individual data items for all publicly traded
companies or for any specified subset of companies.

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